Among the corporate tax increases in the Biden administration’s Made in America Tax Plan to pay for $2 trillion in infrastructure spending is one emerging as a flashpoint: changing the foreign earnings tax regime from allowing the blending of income from different jurisdictions to taxing the global intangible low-taxed income of U.S. taxpayers on a separate-country basis. That would preclude the blending of high- and low-taxed earnings for the foreign tax credit limitation. Advocates emphasize the proposal’s potential to raise large amounts of revenue, and they characterize it as an important measure to advance global tax fairness and protect the tax base of less developed countries.

Meanwhile, some Senate Finance Committee members have released their own proposal with alternatives to country-by-country GILTI. The proposal by Democratic Sens. Ron Wyden of Oregon, Sherrod Brown of Ohio, and Mark R. Warner of Virginia acknowledges that CbC GILTI may be one way to reduce profit shifting but it also advances a simpler alternative: Instead of applying the FTC system to each country separately, GILTI would apply only to income from low-tax jurisdictions, calculated on a combined basis; income from high-tax countries would be subject to a mandatory high-tax exclusion. The senators say that would allow the blending of a large amount of global income with none of the abuses of the current system. They say that would achieve the goals of a CbC system more simply, making it easier for the IRS to enforce. (Related coverage: p. 265.)

This article considers the various claims being made regarding the benefits and drawbacks of moving from taxing foreign earnings under a blended system to a jurisdictional one and weighs those considerations against the senators’ proposal.

CbC GILTI

Background

There are two major ways a blended GILTI calculation could be expected to generate revenue. The first derives from the fact that a separate-country calculation prevents losses generated in one country from offsetting profits made in another. The second has more to do with the FTC allowable for GILTI inclusions than the calculation of the inclusion itself. Because the GILTI foreign taxes are in a separate FTC basket, calculating GILTI by jurisdiction necessarily puts its FTC on a per-country limitation. In that sense, the GILTI CbC calculation introduces a double FTC limitation on GILTI-related taxes: the first because of the separate basket for the type of income, and the second because there’s a per-country limitation in that basket.

The Senate Democrats’ proposal would allow for some netting of losses against profits and create two, rather than multiple, GILTI baskets.

Per-Country FTC

The Biden administration isn’t the first to think of limiting the FTC per country. Since the FTC’s enactment over 100 years ago, attempts to limit U.S. taxpayers’ ability to claim it have swung back and forth for and against the per-country limitation for competing policy reasons, including encouraging U.S. investment overseas, reducing double taxation, raising revenue, and minimizing complexity.

Congress first acted to prevent taxpayers from crediting high foreign taxes against domestic-source income three years after enacting the FTC in 1918. The overall FTC limitation was enacted in 1921 and lasted just over a decade until 1932, when Congress first adopted an FTC limitation that applied the lesser of an overall or per-country limitation. That regime lasted until 1954, when Congress dropped the overall limitation in favor of the per-country one, explaining that “the effect of the overall limitation is unfortunate because it discourages a company operating profitably in one foreign country from going into another country where it may expect to operate at a loss for a few years” (S. Rep. No. 86-1393). The 1954 adoption of the per-country limitation was considered a taxpayer-friendly move.

In 1960 Congress tinkered with the regime again, permitting taxpayers to elect either the overall or per-country limitation. It said that while the per-country limitation might be preferred by taxpayers that are profitable in one country and loss-making in another, it was more common for taxpayers to benefit from the ability to average high and low taxes of different countries. In 1976 Congress removed the electability from the statute, requiring all taxpayers to apply an overall limitation (Karen Kole, “The Status of United States International Taxation: Another Fine Mess We’ve Gotten Ourselves Into,” 9 Nw. Int’l J. Law & Bus. 49 (1988)).

The Reagan administration’s tax reform proposals initially suggested returning to a per-country limitation as a revenue raiser. That met heavy opposition, with taxpayers arguing that it would harm the competitiveness of U.S. businesses. Commentators argued that the per-country limitation presented an “inordinate amount of difficulty” both for taxpayers and the IRS (Richard Pugh and Samuel Sessions, “The Foreign Tax Credit Limitation: An Analysis of the President’s Tax Proposals,” 19 Int’l Law. J. 1239, 1261 (1985)). Instead, the Tax Reform Act of 1986 adopted nine separate basket limitations within the overall limitation.

In reducing the number of baskets to two in 2004, Congress explained that:

In 2017 the two baskets became four with the addition of the GILTI basket and the foreign branch basket.

The Benefits

Revenue

Proponents of CbC GILTI tout the large amounts of revenue that could be raised. In her testimony during a Finance Committee hearing last month, Treasury Deputy Assistant Secretary for Tax Analysis Kimberly A. Clausing said the system could reduce profit shifting to tax havens, which as of 2017 cost the U.S. government approximately $100 billion a year. (Treasury’s April 7 report on the Made in America Tax Plan repeats that point.) In a 2020 Tax Notes article, Clausing said a CbC minimum tax of 21 percent could raise between $570 billion and $910 billion over the next 10 years if foreign profits grow at a rate of 4 percent. (Prior analysis: Tax Notes Federal, Nov. 9, 2020, p. 925.)

Moving to a jurisdictional GILTI system would generate revenue, if for no other reason than by disallowing the offsetting of loss-making jurisdictions against profitable ones. For example, imagine U.S. MNE with two subsidiaries, one in France and one in Ghana. If the French subsidiary operates at a profit but the Ghanaian subsidiary generates a loss, CbC GILTI would necessarily result in a larger GILTI inclusion because the Ghanaian losses wouldn’t offset the French profits. That would make it less likely that U.S. MNE would invest in building the Ghanaian market for its goods.

One could similarly generate more tax revenue from a purely domestic company that has multiple subsidiaries, all in the United States, by not allowing the losses generated by unprofitable businesses to offset the taxable income of profit-generating ones. But the tax law is based on the principle that it’s generally worthwhile — and encourages more long-term investment — to let companies use losses from loss-making ventures to offset the tax liabilities on profitable ones. Not allowing that would make operating overseas less lucrative, and thus discourage U.S. multinationals from expanding their foreign operations.

A CbC GILTI regime could also generate revenue by limiting the availability of FTCs. Consider an example: U.S. MNE has a single subsidiary in France, which has a 40 percent tax rate. If the subsidiary has $200 of pretax income, there would be $80 of foreign taxes. At the current GILTI rate of 10.5 percent (and ignoring the 20 percent haircut and any expense allocation), only $21 of the French tax paid would be creditable. U.S. MNE’s total tax liability would be $80.

Now assume that U.S. MNE has a second subsidiary in Bermuda. The French subsidiary has only $100 of taxable income because it shifted $100 of its profits to Bermuda, which doesn’t tax them. The FTC limitation is still $21, and the $40 of French tax is still fully creditable against the GILTI inclusion.

The projections of large revenues to be generated from CbC GILTI assume that the fact pattern is static. In that case, there would still be $200 of taxable income in the United States, but the $100 of income shifted to Bermuda would be subject to the full U.S. tax on GILTI not offset by any FTC. But that assumption is likely inaccurate. A recent report by the Joint Committee on Taxation (JCX-16-21) containing 2018 tax return data shows that 81 selected corporations (making up one-fourth of all corporate earnings for the year) had GILTI inclusions of $102 billion, with a tentative GILTI liability of $13 billion. They paid foreign taxes associated with that income of $11.8 billion but could credit only $6.6 billion, for a remaining GILTI tax liability after FTCs of $6.3 billion. Based on those numbers, if the GILTI rate was doubled, as Biden proposes, taxpayers should be able to credit that remaining $6.3 billion — meaning no extra revenue for the United States.

The argument that moving to a CbC system coupled with a rate increase would raise revenue is based on additional faulty assumptions embedded in the France-Bermuda example above — that rate disparities among other countries are high enough, and profit shifting is simple enough, to result in a lot more U.S. tax on the Bermuda subsidiary’s income. Those assumptions don’t reflect the changes to tax regimes and in taxpayer behavior caused by base erosion and profit shifting and the Tax Cuts and Jobs Act . More accurate revenue projections would need to consider that taxpayers would likely shift income to where it’s most advantageous from an FTC perspective and how other countries would respond to changes in U.S. tax law.

The senators’ proposal doesn’t contain revenue projections, but by creating just two baskets — for low- and high-taxed income — it potentially avoids some of the worst distortions created by the CbC regime (although not those created by timing differences).

Preventing Base Erosion and Profit Shifting

The Made in America Tax Plan would discourage offshoring by strengthening GILTI. It says the code rewards U.S. multinationals that shift profits and jobs overseas with a tax exemption for the first 10 percent return on foreign assets, while taxing the rest at half the domestic corporate rate, and allows companies to use taxes paid in high-tax countries to shield profits in tax havens, which encourages them to move jobs offshore.

In her Senate testimony, Clausing said U.S. companies continue to shift corporate profits offshore. Together with Emmanuel Saez and Gabriel Zucman, Clausing has also argued that with a high enough rate, imposing a minimum tax on a per-country basis would remove incentives for U.S. multinationals to shift earnings or move real activity to low-tax locales because lower taxes abroad would be offset by higher U.S. taxes (“Ending Corporate Tax Avoidance and Tax Competition: A Plan to Collect the Tax Deficit of Multinationals,” UCLA School of Law, Law-Econ Research Paper No. 20-12 (Jan. 20, 2021)). According to that theory, because there would no longer be incentives for multinationals to operate or book earnings in low-tax countries, there wouldn’t be any point in offering low rates, so tax havens would find it advantageous to increase rates.

U.S. companies have claimed that encouraging other countries to raise their corporate tax rates harms both U.S. businesses (because a net cost for them means less profits to invest in U.S. jobs) and the U.S. fisc (because Treasury must allow more credits against the higher foreign taxes). The winds may have shifted against that argument, perhaps based on the public view that U.S. companies have failed to live up to their part of the bargain by investing overseas and returning excess profits to wealthy shareholders rather than increasing U.S. jobs.

Depending how it’s calculated, the senators’ proposal may or may not provide fewer direct incentives for countries to adjust their rates to the U.S. rate.

Global CbC

In response to the OECD’s initial pillar 2 proposal for a global minimum tax, nongovernmental organizations have universally argued that a per-jurisdiction calculation is necessary to protect the base of source (developing) countries. The pillar 2 blueprint proposes calculating the tax by country and mandating an income inclusion by the headquarters jurisdiction when the effective tax rate in a jurisdiction is below the agreed minimum rate. Determining the jurisdictional effective rate requires first determining the income of each entity and then assigning the income and associated taxes to the relevant jurisdiction.

Although on the surface the Biden plan may be viewed as consistent with the OECD proposal, pillar 2 is more taxpayer friendly in a few important respects. First, the OECD would allow carryforwards and carrybacks in calculating a jurisdiction’s effective rate. The blueprint says that adjustment is intended to ensure that the proposal doesn’t result in the imposition of additional tax when a low effective rate in a given year simply results from a timing difference. Second, the OECD proposal includes a formulaic substance-based carveout intended to exclude from the rule a fixed return for substantive activities in a jurisdiction. That carveout is similar to the qualified business asset investment exemption from GILTI enacted as part of the TCJA, which the Biden plan would eliminate.

The Senate proposal is silent on carryovers but would also eliminate the QBAI exemption.

The Costs

Complexity

In the 100-year seesawing of the FTC limitation, Congress has veered between calculating the credit on a per-country basis and an overall basis no fewer than five times, describing the first as too complex each time it abandoned it.

Calculating the income of multinationals per country might seem simple in theory but it’s much harder in practice. To truly reflect the operational income — and only that income — generated in a jurisdiction, one would want to disregard payments that could easily lend themselves to income shifting, such as interest or royalties. Moreover, one needs to give credit for dividends between entities to ensure income isn’t doubly counted and adjust for inconsistent jurisdictional characterization of entities and instruments for tax purposes. And it’s not necessarily the case that complex rules always work in the government’s favor.

Simplicity is one of the important benefits listed for the senators’ two-basket GILTI proposal. Revising it to reflect appropriate adjustments for timing differences would make it more complex.

Tax Planning

It’s often the case that the more complex the rule, the easier it is for taxpayers to develop workarounds. Consider one obscure rule: the CFC netting provision in the interest expense allocation regulations to ensure that taxpayers don’t incur related-party debt as a way to plan around interest expense allocation rules. That rule opened the door for other planning opportunities by allowing taxpayers to place debt in advantageous places to maximize the FTC limitation (regs have been proposed (REG-101657-20) to modify it).

Complex rules are also harder for governments to audit and enforce. Biden’s tax plan includes additional funds for corporate tax enforcement, but that’s tempered by its added complexity.

Using Losses

U.S. attempts to tax the foreign earnings of U.S. resident taxpayers and prevent them from profit shifting to low-tax jurisdictions has reflected competing considerations — that is, encouraging foreign versus domestic investment. For the most part, that history has been based on a recognition that U.S. investment overseas helps further U.S. foreign policy goals and ensure the long-term profitability of U.S. companies, thereby maximizing their ability to invest domestically. Advancing those objectives would seem to suggest allowing credits for losses incurred by U.S. businesses expanding overseas. (Clausing’s 2019 book, Open: The Progressive Case for Free Trade, Immigration, and Global Capital, highlights the continuing importance of open markets.)

The senators’ proposal allows for some loss offsets and so is friendlier to U.S. overseas investment than Biden’s.

Inversions

The inversion trend that led to the enactment of section 7874 in 2007 and the release of multiple tranches of regulations to tighten those rules subsided only after the TCJA enacted a lower corporate tax. The rate and base changes introduced in 2017 minimized the disparities between U.S. and other tax regimes, thus reducing incentives to invert.

Because it would increase the disparities, the Made in America Tax Plan could be expected to reinvigorate the trend. However, it says it will discourage U.S. companies from inverting by adopting a managed and controlled test for determining corporate residency. It also relies on global adoption of a minimum set of rules to ensure that other countries’ tax systems aren’t more enticing. But managed and controlled tests can be artificially manipulated, and formal adoption of a global standard is unlikely to provide insurmountable barriers to attracting the operations and cash of U.S. multinationals.

How Strong a Global Backstop?

The Biden administration’s claim that a CbC GILTI won’t create distortions between U.S. and other tax systems appears to rest on the belief that the United States can strong-arm the rest of the world into adopting a similar system. On April 5 Treasury Secretary Janet Yellen called on other countries to join the United States in adopting a global minimum tax. But all that mostly ignores that other countries have rejected strong CFC rules or might be willing to reach formal agreements while circumventing the rules to ensure their jurisdictions remain favored locales for foreign investment.

In contrast, the senators’ plan might work well even if other countries reject pillar 2.

Conclusion

If enacted on a partisan basis and in the face of strong business opposition, a CbC GILTI regime is probably a sitting duck waiting for repeal by the next Republican administration. Further, adding instability and uncertainty to the international tax rules likely undermines Biden’s supposed goal of encouraging domestic investment. A simpler option that builds on the Senate’s two-basket system could provide a constructive basis for business interests and Democrats to work together to improve the TCJA’s international rules.

Mindy Herzfeld is professor of tax practice at University of Florida Levin College of Law, of counsel at Ivins, Phillips & Barker, and a contributor to Tax Notes International.